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Rekenthaler Report

Performance Fees Were the Least of This Fund's Sins

Putnam Capital Spectrum was born to fail.

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Improper Grading?
This spring, The Wall Street Journal's Jason Zweig called out Putnam Capital Spectrum (PVSAX) for competing against an inappropriate benchmark. Unusually for a mutual fund, Putnam Capital Spectrum assesses a performance fee, which rewards or penalizes a fund based on how its returns compare to those of an unmanaged index. For Capital Spectrum, Putnam created a customized benchmark that consists of 50% U.S. stocks and 50% global developed-markets junk bonds.

As Jason pointed out, that choice raises suspicions that Putnam gamed the system, because over its 11-year history the fund has almost always held more than half its assets in stocks. The average has been 70%, with the percentage in late 2017 reaching as high as 88%. Wrote Jason, "Because, over time, stocks usually outperform bonds, a fund with the bulk of its holdings in stocks stands a good chance of beating a benchmark that consists of 50% bonds."

Putnam's response: Because Capital Spectrum was fortunate enough to begin operations in May 2009, the fund has spent almost its entire history investing in a stock bull market. Consequently, the fund has held more equities that it normally would. Far from benefiting from rigged results, Putnam Capital Spectrum's management astutely recognized the opportunity. It merits bonuses, not rebukes.

Jason's argument is the more compelling of the two, since the stock market generally goes up rather than down. One therefore suspects that Capital Spectrum's default position is indeed equity-heavy, with adjustments made during relatively infrequent bear markets. But I can't condemn the fund too strongly. Even when collecting its full performance fee, its total expenses aren't much above most rivals', and in recent years they have been well below average.

Sometimes, Cheaper Is Not Better
Which brings us to Putnam Capital Spectrum's larger problems. The fund's currently low expense ratio (only 0.06% for its institutional shares) is not to be celebrated. When owning a fund that levies performance fees, investors are best served by paying the maximum amount. Receiving the consolation prize of unexpectedly low costs is no bargain; whatever shareholders saved in fees, they more than conceded in relative performance.

The fund's recent showing, to phrase the matter delicately, has been wretched, as its trailing five-year return of negative 2.3% lands in its category's 99th percentile. (Morningstar classifies the fund according to how it invests, which places Putnam Capital Spectrum in the inelegantly named group of allocation--70% to 85% equity.) Those losses didn't come gently, either, as the fund dropped by 24% in calendar-year 2018. Drop the expense ratio to zero, that remains a terrible investment.

Imploding, sadly, was always the fund's expected outcome. It was launched and billed as a "go anywhere" investment--a breed that has failed since forever. No mutual fund manager has consistently been able to shift among asset classes and between countries. Some have posted strong stretches, as did Putnam Capital Spectrum during its first few years, but ultimately all go-anywhere funds get caught out.

Rise and Fall
When the inevitable downturn occurs, shareholders almost always bail. It's difficult enough to hold a loser when the only culprit is behavior of the overall market, as with index funds. It's harder yet when facing the second uncertainty, whether management has "lost its touch." Few investors can withstand the double pressure. Putnam Capital Spectrum's shareholders were no exception. They took the fund from nothing to $10 billion over its first six years, and then back to whence it came. It is now worth only $400 million. 

In aggregate, they got soaked. The fund took four years to reach $3 billion, meaning that most shareholders only arrived for the final two years of its good performance. From 2015 onward, when the fund reached peak assets, the cumulative total return has been negative. Since its inception, the fund's paper gains remain comfortably positive--but most people who bought the fund lost money. Such is the fate of go-anywhere funds.

So, too, is early termination. Had it not been for COVID-19's intrusion, which stymied the shareholder vote scheduled for April 21, Capital Spectrum would already be extinct. Instead, it is a dead man walking, with the vote for its liquidation scheduled for Aug. 5. Such motions always pass, pandemic conditions excepted. When this action does, Capital Spectrum and its sibling Equity Spectrum (PYSAX) will disappear, being merged into Putnam Focused Equity (PGIAX).

Putnam 1, Shareholders 0
No questions need be raised about the new fund's asset allocation, as Putnam Focused Equity is 100% invested in stocks. But, of course, that wasn't the tactic promised to Capital Spectrum's buyers. Nor, I suspect, will shareholders be delighted by Focused Equity's track record, which barely exists. Before last summer, Focused Equity was called Putnam Global Industrials and followed a different strategy.

(Morningstar has opted to display Putnam Focused Equity's pre-revision results, but I wouldn't pay those figures much attention, as Focused Equity quickly jettisoned Global Industrials' positions.)

The story gets worse. Technically, Putnam Focused Equity isn't solely the updated face of Global Industrials, because when the change was made, the asset base also received the corpse of Putnam Global Natural Resources. Thus, when next month's merger occurs, Focused Equity will be a Frankenstein's monster constructed of four dead funds, which had a combined life span of 73 years. The fund's track record in its current form will be a mere 14 months. 

You may be wondering, what happened to Putnam Capital Spectrum's performance fee? Because that fee was based on trailing 36-month results, the fund's disastrous 2018 would have slashed its revenues for at least the next year. Not so after the liquidation. Under the new terms, those assets will not be penalized for the fund's previous showing. Rather, they will be assessed Focused Equity's standard management fee, which is several times higher than what Capital Spectrum was collecting.

Those wondering why index funds incessantly gain market share, and why fund companies that promote actively managed funds lose ground, need look no further than the case of Putnam Capital Spectrum.

Isn't It Ironic?
The director of the Free Enterprise Project kicked my column "The Department of Labor Attempts to Throttle ESG Investing" down the stairs, through the door, and out to the street. I won't attempt to refute his complaints, since he was upset not at what I wrote, but what somebody would have written if he had defended the practice of ESG (which that column absolutely, positively did not).

But I am puzzled. My column addressed a proposal by the DOL to limit the investment activities of private corporations. Why would somebody who advocates for "free enterprise" aggressively support a new government regulation that would restrict the freedoms of, ahem, free enterprises?

I haven't yet sorted that one out. If you think you can explain how libertarian principles support the DOL's investment-restraining proposal (and can do so politely), feel free to send me a note. I am skeptical that such an argument can succeed, but I have been known to be wrong before.

 

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

John Rekenthaler does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.